The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Wednesday, February 13, 2013

Barclays is symptom of global problems in finance that only transparency fixes

In his Guardian column, Joris Luyendijk looks at what Anthony Jenkins is trying to achieve in fixing Barclays and sees three major reasons why it won't work.

Each of the reasons cited by Mr. Luyendijk is fixed if Barclays adopts transparency as the foundation of its business and culture.

There are three huge problems with the way global finance works today.

One is that the sector's internal checks and balances are broken, meaning the system no longer self-corrects. In theory, risky and fraudulent behaviour should be spotted by accountancy firms and credit rating agencies.

Actually, the way our global financial system is designed under the FDR Framework, accountancy firms and credit rating firms are just two of the market participants who should be on the look out for risky and fraudulent behavior.

The ultimate backstop for their efforts are the investors.

Under the FDR Framework, investors are responsible for all losses on their exposures under the principle of caveat emptor (buyer beware). This gives the investors the incentive to look out for risky and fraudulent behavior.

The necessary condition for investors to do this is that there is transparency. Specifically, they have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Global finance's internal checks and balances are broken because the regulators have let large areas of the financial system become opaque. This includes banks, structured finance securities and benchmark interest rates like Libor, Euribor and Tibor.

However, in the current setup, both are financially dependent on the very banks they are supposed to be a check on.

Imagine it was the restaurants that paid the salaries of the Michelinreviewers. Expect to see a lot more stars or triple-A ratings.

One of the benefits of transparency is that it minimizes the conflict set up by financial dependency.

It minimizes this conflict by letting market participants effectively monitor how well accountancy and credit rating firms are doing their jobs. Specifically, when market participants have transparency, market participants can monitor the performance of accountancy and credit rating firms (as well as other market participants like financial regulators).

For example, market participants can monitor the performance of credit rating firms by independently assessing the same information available to the credit rating firms themselves or by hiring third party experts. Market participants can compare their internal assessment to the credit rating firms' assessment.

The ability to monitor instills a discipline to error on the side of the investors and not to succumb to financial dependency.

This failure of self-correction is compounded by market failure at the top of the global financial sector.

When companies perform as disastrously as the big global banks, accountancy firms and credit rating agencies did before 2008, economic theory predicts new entrants into the market. But we haven't seen a single new bank or rating agency break through.

What this means is that at the apex of the world economy there is no competition but a cartel; three big rating agencies, four big accountancy firms and a dozen "bulge-bracket" global banks.

In their turn, the external checks and balances are also broken – or rather, co-opted.

Talented regulators and central bankers are offered life-changing salaries by the big banks, while politicians can look forward to formidable campaign donations while in office and highly lucrative jobs afterwards.

Hoping for a politician to come forward with a clear blueprint for what a stable and moral financial sector looks like, and a roadmap of how to get there? Don't look to Tony "light-touch regulation" Blair, who receives £2.5m a year for unspecified "advice" from JP Morgan.

Five years ago we came terrifyingly close to a total economic collapse. ... It nearly happened, but since then nothing has been achieved in the way of fundamental, structural reform.

Your humble blogger has said since the beginning of the financial crisis that what is needed is not heroic fundamental, structural reform.

We have in place a global financial system that has shown for 7+ decades that it can function properly when there is transparency.

Where the system collapsed five years ago and is still not working is in all those corners that are shielded by a veil of opacity.

Fixing the system is simple. Bring transparency to all the opaque parts of the financial system.

What has been missing is the political will to bring transparency to all the opaque corners of the financial system.

Indeed, things are worse now, with even bigger banks than in 2008.

This reflects the choice by the US Treasury and the Federal Reserve to unilaterally adopt a policy of financial failure containment and at the same time abandon the policy of financial failure prevention that is at the heart of the FDR Framework.

It has been known since the 1930s that opacity is the necessary ingredient for bankers to extract excess rent. That is why the financial regulators under the FDR Framework were given the sole responsibility of ensuring there was transparency in the financial system and in each financial product.

With the abandonment of the policy of financial failure prevention, the financial regulators also abandon their responsibility of ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

To put into perspective how far the global financial regulators are from fulfilling their responsibility of ensuring transparency, Principia did a survey of investors in structured finance securities.

The investors were asked about the global effort to bring transparency to opaque structured finance securities. 59% of the investors said that if everything that were currently under discussion by the global financial regulators was implemented there would still not be sufficient disclosure to perform adequate due diligence.

This result reflects both the emergence of the Blob and the adoption of Wall Street friendly policies like financial failure containment.

What we need is a breaking up of the global financial cartel into bits that are not only small enough to fail but that also actually compete, driving out bad practices and driving down profits.

If there were transparency, there would be market discipline exerted on the banks. This would both drive out bad practices and lower profits by eliminating the possibility of extracting excess rent.

Market discipline also has the added benefit of it would force the large, global banks to lower the risk profile of their business. One way to do this would be to split themselves up.

What we get is a tacit acceptance of the status quo by politicians in big bank-hosting nations, covered up by promises to change the culture of finance.

Not just acceptance, but it is an explicit goal of the financial failure containment policy to protect the status quo. After all, the policy didn't work if as a result of a financial crisis, the big banks that existed before the crisis don't exist afterwards.

Perhaps the problem is that the major banks operate on a global scale, while responses to them must be formulated on a national level.

Which brings us to the unresolved issue five years after the crisis: can you even have a global financial sector without a global regulator?

There is one global regulator in the financial system and that is the global financial market itself. By definition, the global financial market is bigger than any global banking organization.

One of the reasons that I have championed transparency is that transparency can be implemented globally. In fact, once one country adopts transparency for its financial institutions it triggers a race to the top.

The race is triggered because transparent financial institutions have a competitive advantage in terms of lower cost funding.

Why do they have lower cost funding? Because with transparency, they have nothing to hide and market participants can independently assess their risk.

By definition, every bank that does not provide transparency is waving a red flag and saying they have something to hide. Given the banks have something to hide, it is clear they are riskier and therefore they should have a higher cost of funds.

So it turns out that there is a nation level response that can solve the global problems in finance. The question really is, where are the national policymakers who put their society ahead of their bankers and the promise of life-changing salaries?

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.